As part of the Fed’s year-long review of its monetary policy strategy, tools and communications practices, the St. Louis Fed is assembling members of its six advisory councils, representing a geographically and industry-diverse group of stakeholders.

Central View: Many Community Banks Must Make Tough ROE Choices

At year-end 2007, before the reverberations of the global financial crisis began to be felt across most business sectors, there were 7,139 community banks in the U.S. By the end of 2011, that number had slipped to 6,155. More than one-third of the decline, or 342 charters, occurred because of institutions that failed. The 642 other banking organizations found strategic partners to bolster their financial strength or improve operating efficiencies.

The 14 percent decline in charters in just four years is reflective of the challenges facing banks over that time, especially community banks. And headwinds prevail: Revenue opportunities continue to be limited, operating costs are climbing and the uncertainty of added regulation remains a concern.

To be fair, some of the recent data on community bank performance have been positive. Problem asset ratios have declined, and earnings performance has improved. Moreover, banks facing asset quality difficulties are working hard to improve their balance sheets through prudent loan restructures, asset disposals and the redeployment of funds into less concentrated market sectors.

I am often asked, “What lies ahead?” No one has a crystal ball, but one area of the balance sheet that may not recover to pre-crisis levels is return on equity (ROE).

Community banks consistently express concerns about profit opportunities, given current weak loan demand and the possibility of growing regulation. Community bank managers are going to have to make some tough choices over the next few years. They will need to identify areas where they can reduce costs. They might eliminate business lines that are no longer profitable (even if they are legacy businesses) and focus on their core areas of expertise and profitability. All of this uncertainty only underscores the importance of having a strong management team at the bank.

If the bank cannot make such adjustments, investors in community banks may need to adjust their expectations for returns on equity. Depending on the length and depth of low returns, some investors may turn elsewhere, requiring some additional consolidation of the industry to scale growing costs.

The community bank model in the U.S. has withstood numerous challenges throughout its history. Despite some recent positive signs, bank managers can’t ignore the headwinds they’re facing. The next few years will be crucial in understanding what it will take for community banks to return to historic profitability.